Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Academic Board Chairman of the Asia Global Institute in Hong … read more

Mind over Market

MILAN – In the 66 years since World War II ended, virtually all centrally planned economies have disappeared, largely as a result of inefficiency and low growth. Nowadays, markets, price signals, decentralization, incentives, and return-driven investment characterize resource allocation almost everywhere.

This is not because markets are morally superior, though they do require freedom of choice to function effectively. Markets are tools that, relative to the alternatives, happen to have great strengths with respect to incentives, efficiency, and innovation. But they are not perfect; they underperform in the presence of externalities (the un-priced consequences – for example, air pollution – of individual actions), informational gaps and asymmetries, and coordination problems when there are multiple equilibria, some superior to others.

But markets have more fundamental weaknesses. Or, rather, most societies have important economic and social objectives that markets and competition are not designed to achieve. In today’s rapidly globalizing world, the most important of these objectives – expressed in various ways through the political and policymaking process in a wide range of countries – are stability, distributional equity, and sustainability.

Consider stability. We live in a world of largely decentralized networks of increasing complexity: electronic networks, networks of supply chains and trade, financial networks that link the balance sheets of disparate entities. Market incentives cause actors to operate or modify parts of the network in ways that maximize efficiency locally. But the presumption – often an article of faith – that the whole remains stable and resilient has no theoretical or empirical support. Indeed, it seems inaccurate.